In Depth

Despite growing concerns over global inflation, the struggling U.S. dollar, a potential bust in the commodities market and hedge funds using excessive leverage, Wall Street bigwigs say the U.S. economy is in for a “pillow-case” landing this year, poised for further growth.

Under-owned, Underleveraged

Michael Hartnett, chief global emerging markets strategists at Merrill Lynch, said that 2007 will be a strong year for emerging markets, particularly in Asia.

“We’re in the midst of a great bull market as far as this decade is concerned in emerging markets, and the leadership within the bull market has been very much led by the BRIC markets,” he said, speaking at the annual Dow Jones Indexes/STOXX Ltd. Global Economic Outlook. “[Emerging markets] used to be the problem teenager of the equity world over the course of their 20-year history, but have now grown up.”

Hartnett predicts that emerging markets will be up somewhere between 10% and 20% this year—a far cry from the 35% annualized that the markets have experienced over the last three to four years.

“We think it is nowhere near over and this bull market will end like all great bull markets, with visible greed, leverage and egregious valuations,” he said, but adds that, right now, emerging markets are an undercapitalized, underleveraged and under-owned asset class.

“There’s another 40% to 50% upside in the next two to three years,” Hartnett said. “There is more mortgage debt in Manhattan than all of Russia, and similarly in China, India and Brazil where you have an underleveraged economy and corporate sector.”

There are risk factors that could harm performance in those regions, such as global inflation, the strength of the U.S. dollar, a credit event and a protectionist policy in emerging markets countries, Hartnett said, adding that the best returns will come from non-BRIC markets. “BRIC markets, on a P/E trading basis, is at a 605 premium to non-BRIC markets, so non-BRICs are the way to go this year,” he said.

Devil’s Advocate

Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., expects the level of liquidity to “continue to be a positive force until it’s not anymore,” but cautions investors about growth in 2007. “Clearly, we’re in a deceleration for earnings growth and I think there’s a risk that if we saw deceleration beyond the mid-single digit range, then we might have some volatility in the market,” Sonders said.

Sonders does anticipate higher volatility in 2007. However, she warns against decision-making based on the Federal Reserve chairman’s words. “Investors here hang on every word from Ben Bernanke, and I think we’re doing the investors a disservice by only focusing on the U.S. central bank,” she said. “We have to get out of the sandbox when it comes to analyzing central bank policies and in this global economy we have to be mindful of what every other central bank is doing.”

Also, Sonders said there is a big gap between smart money sentiment indicators and dumb money indicators. “There is a lot more optimism on the part of dumb money measures than there is by smart money. Hedge funds, which traditionally have been considered smart money and the non-contrarian indicators, to some degree have now become a contrarian indicator largely because of some of the money invested in hedge funds.”

A Cause For Concern

The U.S. dollar’s outlook this year hinges largely on whether the American economy has a soft or hard landing, according to Rebecca Patterson, global currency strategist with JPMorgan Chase. Ironically, Patterson said a hard landing could prove the best-case scenario for the dollar, as it would likely narrow the current account deficit and lead to repatriation of U.S. capital invested abroad.

“We believe that that U.S. current account this year could widen to 7% of GDP, so it is not going away, and in fact the risk is that it is going to get bigger,” she said. “Analysts, investors and even reporters who say the dollar must go down because of the current account are only telling you half the story, because the current account by itself has a terrible relationship with the dollar; half the time the dollar goes the same way as the current account and half the time it doesn’t.”

The dollar is weak and will remain so throughout the year, according to Patterson, with euro excahnge rate ending this year around US$131 and dollar-yen rate staying near current levels, possibly going as high as ¥125 during the course of 2007.

“The European Central Bank and Bank of Japan will raise rates this year but the market is already looking for rate hikes and this would lead short-term buyers like hedge funds to be buying the dollar,” she says.

JPMorgan forecasts 2.8% GDP growth for this year with the pace picking up over the course 2007 to the tune of 3% to 3.5% by the second half of this year, says Patterson. “So by no means are we in the recession or the hard landing stand; it’s a very soft, pillow-top comforter sort of landing.”